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Credit Risk and Profitability of Selected Banks in Ghana


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Credit Risk and Profitability of Selected Banks in Ghana

  1. 1. Credit Risk and Profitability of Selected Banks in Ghana Samuel Hymore Boahene Internal Audit Officer, International Commercial Bank (Ghana) Limited, Accra-Ghana. Email: +233 (0) 261 690 125 Dr. Julius Dasah Bank of Ghana Accra - Ghana Samuel Kwaku Agyei Department of Accounting and Finance, School of Business University of Cape Coast, Cape Coast-Ghana Email: +233 (0) 277 655 161AbstractThis study attempts to reveal the relationship between credit risk and profitability of some selected banks in Ghana.A panel data from six selected commercial banks covering the five-year period (2005-2009) was analyzed within thefixed effects framework. In Ghana, the average lending/interest rate is about 30% - 35% per annum. From theresults credit risk (non-performing loan rate, net charge-off rate, and the pre-provision profit as a percentage of nettotal loans and advances) has a positive and significant relationship with bank profitability. This indicates that banksin Ghana enjoy high profitability in spite of high credit risk, contrary to the normal view held in previous studies thatcredit risk indicators are negatively related to profitability. Our results can be attributed to the prohibitivelending/interest rates, fees and commission (non- interest income) charged. Also, we found support for previousempirical works which depicted that bank size, bank growth and bank debt capital influence bank profitabilitypositively and significantly.Keywords: Credit Risk, Profitability, Banks, Ghana.1.0 IntroductionEven though one of the major causes of serious banking problems continues to be ineffective credit riskmanagement, the provision of credit remains the primary business of every bank in the World. For this reason,credit quality is considered a primary indicator of financial soundness and health of banks. Interests that are chargedon loans and advances form sizeable part of banks’ assets. Default of loans and advances poses serious setbacks notonly for borrowers and lenders but also to the entire economy of a country. Studies of banking crises all over theworld have shown that poor loans (asset quality) are the key factor of bank failures. Stuart (2005) stressed that thespate of bad loans (non-performing loans) was as high as 35% in Nigerian Commercial Banks between 1999 and2009.Umoh (1994) also pointed out that increasing level of non-performing loan rates in banks’ books, poor loanprocessing, undue interference in the loan granting process, inadequate or absences of loan collaterals among otherthings, are linked with poor and ineffective credit risk management that negatively impact on banks profitability.As a result of the likely huge and widespread of economic impact in connection with banks failure, the managementof credit risk is a topic of great importance since the core activity of every bank is credit financing. According to thebank theory, there are six (6) main types of risk which are linked with credit policies of banks and these are; creditrisk (risk of repayment), interest risk, portfolio risk, operating risk, credit deficiency risk and trade union risk.However, the most vital of these risks, is the credit risk and therefore, it demands special attention and treatment.This paper attempts to make a modest contribution to literature on credit risk by assessing its impact on a developingeconomy, Ghana. The rest of the paper is organized into four sections: review of relevant literature; methodology;discussion of empirical results; and summary and conclusions. 1
  2. 2. 2.0 Review of Research LiteratureThe significant role played by banks in a developing economy like Ghana (where access to capital market is limited)cannot be overemphasized. In fact, well functioning banks are known as catalyst for economic growth whereaspoorly functioning ones do not only impede economic progress but also exacerbate poverty (Barth et al, 2004).However banks are exposed to various risks such as credit, market and operational risk. Although all these riskmilitate against the performance of banks in several ways, Chijoriga (1997) argues that the size and the level of losscaused by credit risk as compared to others were severe to collapse a bank.2.1 Credit Risk Management System of BanksNumerous researchers had studied reasons behind bank problems and identified several factors (Chijoriga, 1997,Santomera 1997, Brown, Bridge and Harvey, 1998). Problems in respect of credit especially, weakness in creditrisk management have been identified to be the main part of the major reasons behind banking difficulties. Loansforms huge proportion of credit as they normally accounted for 10 – 15 times the equity of a bank (Kitwa, 1996).In this way, the business of banking is potentially faced with difficulties where there is small deterioration in thequality of loans. Poor loan quality starts from the information processing mechanism (Liuksila, 1996) and thenincrease further at the loan approval, monitoring and controlling stages. This problem is magnified especially, whencredit risk management guidelines in terms of policy and strategies and procedure regarding credit processing do notexist or are weak or incomplete. BrownBridge (1998) observed that these problems are at their acute stage indeveloping countries.In order to minimize loan losses as well as credit risk, it is crucial for banks to have an effective credit riskmanagement systems in place (Santomera 1997, Basel 1999). As a result of asymmetric information that existsbetween banks and borrowers, banks must have a system in place to ensure that they can do analysis and evaluatedefault risk that is hidden from them. Information asymmetry may make it impossible to differentiate goodborrowers from bad ones which may culminate in adverse selection and moral hazards have led to hugeaccumulation of non-performing accounts in banks (Baster, 1994, Gobbi, 2003).Credit risk management is very vital to measuring and optimizing the profitability of banks. The long term successof any banking institution depended on effective system that ensures repayments of loans by borrowers which wascritical in dealing with asymmetric information problems, thus, reduced the level of loan losses, Basel (1999).Effective credit risk management system involved establishing a suitable credit risk environment; operating under asound credit granting process, maintaining an appropriate credit administration that involves monitoring, processingas well as enough controls over credit risk (Greuning and Bratanovic 2003). Top management must ensure, inmanaging credit risk, that all guidelines are properly communicated throughout the organization and that everybodyinvolved in credit risk management understands what is required of him/her.The management of credit risk in banking industry follows the process of risk identification, measurement,assessment, monitoring and control. It involves identification of potential risk factors’, extrapolate theirconsequences, monitor activities exposed to the identified risk factors and put in place control measures to preventor reduce undesirable effects. This process is applied within the strategic and operational framework of bankingbusiness.Sound credit risk management system are policies and strategies (guidelines) which clearly outline the purview andallocation of a bank credit facilities and the way in which credit portfolio is managed; that is, how loans wereoriginated, appraised, supervised and collected (Basel, 1999; Greuning and Bratanovic 2003, Pricewaterhouse,1994). The activity of screening borrowers had widely been recommended by, among other, Derban et al, (2005).The theory of asymmetric information from prospective borrowers becomes critical in achieving effective screening.In screening loan applicants, both qualitative and quantitative techniques should be used with due consideration fortheir relative strength and weaknesses. It must be stressed that borrowers attributes, assessed through qualitativemodels can be assigned numbers with the sum of values compared to a threshold. This technique is termed as“credit scoring” (Heffernan, 1996). The rating systems, if meaningful, should signal changes in expected level ofloan loss (Santomero, 1997). Chijoriga (1997) posited that quantitative models make it possible to among others,numerically establish which factors are important in explaining default risk, evaluate the relative degree ofimportance of the factors, improving the pricing of default risk, be more able to screen out bad loans application andbe in a better position of calculate any reserve needed to meet anticipated future loan losses. 2
  3. 3. Establishing a clear process for approving new credit and extending the existing credit (Heffernan, 1996) andmonitoring credits granted to borrowers (Mwisho, 2001) are considered important when managing credit risk(Heffernan, 1996). Instruments or tools such as covenants, collateral, credit rationing, loan securitization andsyndication have been used by banks in developing countries in controlling credit losses. (Benveniste and Bergar1987). It has also been identified that high-quality credit risk management staff are critical to ensure that the depthof knowledge and judgment needed is always available, thus ensuring the successfully management of credit risk inbanks (Koford and Tschoegl, 1997 and Wyman, 1999).2.2 Credit Portfolio ManagementSupervisors of banks more often than not, place considerable importance on formal policies which are laid down bytheir boards and aggressively implemented by management. This is most critical with regard to banks’ lendingfunction, which stated that banks adopted sound systems for managing credit risk (Greuning and Bratanovic, 1999)In order to appropriately analyse credit risk factors, banks’ chief credit risk officers are required to have detailunderstanding of the principal economic factors that drive loan portfolio performance and the relationship betweenthose factors. Most credit risk officers in the banking industry analyse factors such as; inflation, the level of interestrates, the GDP rate, market value of collaterals among others, for banks in mortgage financing. Also, traditionalfinancial management texts posit that credit manager would take note of the five Cs of credit – character, capacity,capital, collateral and conditions to evaluate the probability of default (Casu et al,2006; Zech,2003). These factorsare in line with the arbitrage pricing theory of Stephen Ross which is the most applicable to loan portfoliomanagement.According to Uyemura and Deventer, (1993), many techniques in equity portfolio management were applicable inindividual loans or loan category which can be measured by the dependence of the loan’s return on the factorsmentioned. It should be noted that lending policy should contain an outline of the scope and allocation of banks’credit facilities and the manner in which credit portfolio is managed. That is to say that, how loans are originated,serviced, supervised and collected. Banks must bear in mind that a good lending policy is not overly restrictive, butallow for the presentation of loans to the board that officers believe are worthy of consideration but which do not fallwithin the parameters of written guideline. A sound lending policy should consider; limit on total outstanding loans,geographic limit, credit concentration, distribution by category, type of loans, maturity, loan pricing, lendingauthority, appraisal process, maximum ratio of loan amount of the market value of pledged, recognition,impairment, collection and financial information.2.2.1 Value at – Risk (VaR) As a Tool For Portfolio OptimizationBanks are able to move near to the efficient frontier by diversifying their portfolio and also by adequately pricingloans and insuring appropriate risk return relationship for each loan in the portfolio. The optimal level or point onthe risk return relationship depends on the risk preferences of banks. Which are influenced by the regulators whowould like to minimize the risk and also by shareholders (investors) who prefer high returns. Banks can vary theirportfolio risk-return trade-offs by making new loans, selling existing loans and using derivatives especially in thedeveloped countries like U.S. and UK.However there are shortcomings in this modern portfolio theory when applied to loan portfolios. First of allmanagers perceive risk in term of cedi or dollar loss while standard deviation which is in the efficient portfoliofrontier defines risk in terms of deviation from expected return, hence it is not intuitive. Secondly, the use ofstandard deviation assumes normal distribution whereas the distributions of returns in loan portfolio are skewed.Due to these shortcomings in the modern portfolio theory, Value-at-Risk (VaR) becomes alternatives whichovercome the shortcomings mentioned. VaR measures portfolio risk by estimating the loss in line with a givensmall probability of occurrence. A higher risk means a higher loss at the given probability. VaR is a forecast of agiven percentile usually in the lower tail (such as 99th percentile) of the distribution of returns (or losses) on aportfolio over some period. Again it is an estimate to be equaled or exceeded with a given, small probability such as1%. However, when returns are normally distributed, VaR conveys exactly the same as the information as standarddeviations. Hence, the VaR appeal can be consistent with modern portfolio theory. In this way, VaR method is seento be consistent with modern portfolio theory. VaR measures portfolio risk as alternative to the standard deviation ofreturns realizing bank’s risk preferences posits that, there is an optimal level of VaR for a given portfolio. Thechoice of confidence level of VaR shows risk aversion of a bank. The optimal level of VaR for a portfoliorepresents the optimal level of capital to back the portfolio. VaR approach is having ongoing studies by researchers 3
  4. 4. because of the promise hold for improving risk management, by knowing the risk of the overall portfolio and eachloan, necessary for banks to get nearer to the efficient frontier. The optimal amount of capital or equity to cushenagainst the desired level of risk can be identified, given the risk presence of a bank. The VaR approach is the mostpreferred to be used when the market risk is measured (Schacter, 1998: Zech, 2003: Markowitz, 1959: Hull, 2007).2.3 The Basel Capital Accord and Banking in GhanaBanks maintain adequate capital to safeguard them from the risk inherent in their portfolios. Banks have three typesof capital. That is book capital, regulatory capital and economic capital. Economic capital serves as a cushion tounexpected losses. The introduction of the Basel Capital Accord in 1988 has offered for the implementation of acredit risk measurement framework with a minimum permanent capital ratio of 8% by the end of 1992. Becausebanks are competing globally, it was thought vital to create equal wave length by taking regulation uniformthroughout the world. In 1995 the capital requirements for credit risk were modified to incorporate netting. In 1996the Accord was modified to factor in a capital charge for market risk. Sophisticated banks could base their capitalcharge on a value-a-t risk (VaR) calculation, Hull, (2007). In 1999 the Basel committee suggested some changeswhich were intended to be operationalised in 2007. The new capital accord (Basel II) framework under Pillar 1offers three (3) main approaches for the calculation of capital requirements. These are standardized approach, thefoundation and internal Rating Basel (IRB) Approach and the Advanced IRB Approach.The Bank of Ghana (BoG) has done a number of consultations in the Ghanaian banking industry and has concludedto adopt the standardized Approach for computing the capital requirement for credit risk. This approach has two (2)main methods. These are internal credit ratings approach which is subject to the prior explicit approval of thesupervisor and the other alternative is the use of the external credit assessment approach. The Capital AdequacyFramework for capital requirement directive issued by Bank of Ghana (BoG, 2008), stipulated that locallyincorporated licensed banks were to adopt the standardized approach with the credit ratings specified in calculatingtheir capital requirements. BoG recognized both the simple and comprehensive approaches for credit mitigation. Italso specified eligible final collateral, allowed as credit risk mitigants for the purpose of calculating capitalrequirements for credit risk. Consequently, the Basel II has been in operation since the beginning of 2012,representing the most significant change to the supervision of banks. The focus is on establishing the capital banksrequire, given their risk profiles and improve risk management. The new capital requirements may lead to animproved buffer for risk absorption in the industry. 2.4 Credit Risk and Bank PerformanceBanks that have higher loan portfolio with lower credit risk improve on their profitability. Angbazo (1997) stressedthat banks with larger loan portfolio appear to require higher net interest margin to compensate for higher risk ofdefault. Cooper et al (2003) add that variations in credit risks would lead to variations in the health of banks’ loanportfolio which in turn affect bank performance. Meanwhile, Ducas and McLaughlin (1990) had earlier argued thatvolatility of bank profitability is largely due to credit risk. Specifically, they claim that the change in bankperformance or profitability are mainly due to changes in credit risk because increased exposure to credit risk leadsto fall in bank performance and profitability.Heffernan (1996) stressed that credit risk is the risk that an asset or loan becomes irrecoverable, in the case ofoutright default or the risk of delay in servicing of loans and advances. Thus, when this occurs or becomespersistent, the performance, profitability, or net interest income of banks is affected. Consequently, this study seeksto find out the relationship between credit risk and bank performance of some selected banks in Ghana.3.0 Methodology The core objective of this study is to ascertain the relationship between credit risk and bank profitability. Theprimary data used for the study were from secondary sources especially from financial statements of the banks. Datawas obtained from six banks in Ghana. They included Ghana Commercial Bank Limited (the largest bank in Ghana),International Commercial Bank Limited, Calbank Limited, UT Bank Ghana Limited, First Atlantic Merchant BankLimited and Unibank Ghana Limited. Purposive sampling technique was used in selecting these six banks. The basicdata was obtained from the Annual Report of the banks from 2005 – 2009.3.1 The ModelThe basic model used for the study is written as follows: 4
  5. 5. ROEi,t= α0 + βNCOTLi,t + δNPLRi,t + θPPPNTLAi,t+ ØSIZEi,t+ ΦGROi,t+ γTDAi,t+ εi,tWhere the variables have been explained in Table 1The dependent variable in the model is Return on Equity while the explanatory variable is Credit Risk which ismeasured by three main variables- Net Charge Off to Total Loans and Advances, Non-Performing Loans to TotalLoans and Advances and Pre-provision Profit to Total Loans and Advances. The researcher also controlled for theeffects of other factors on firm profitability. These include bank size, bank growth rate and the choice of capitalstructure.3.2 Measurement of Credit RiskJorion (2007) pointed out that “credit risk is the risk of losses owing to the fact that counterparties may be unwillingor unable to fulfill their contractual obligations”. Generic factors that affect credit risk are default, downgrade,market and recovery risk. Default risk is the uncertainty regarding counterparty’s ability to service debts andobligations and it is measured by the probability of default. The downgrade “was the probability and value impact ofchanges in default probability” (Crosbie and Kocagil 2003). Thus, it considers the effects in relation to thedeterioration of the borrower’s credit quality. The extreme form of downgrade is default.TRNC(2006) and USAID (2006) observed the basic credit risk ratios or indicators are the following: Ratio of Non-performing Loan to Total Loan; Annual provision for loan loss to Non performing loan; Non performing loan toTotal Equity Capital; Annual provisioning for loan loss to Total Equity Capital; Pre-provisioning profit to TotalLoan and Advances; Total Equity Capital to Total Loan and Advances; Net Charge Off (Impairment) to Total loanand Advances and; Total Loan and Advances to Total Deposit. All the ratios mentioned above, if they are increasingover a period, indicate deterioration of a bank’s capacity absorb loan losses. If the ratios increase continuously theyshow the capacity of a bank continuously deteriorating hence, indicate poor credit risk management. However, if theratios decrease continuously over a period, then it implies that a bank has adequate capacity to absorb loan losses,and hence indicate good credit risk management. In this study, the researchers used Net Charge Off (Impairment) toTotal loan and Advances, Non-performing Loans to Total Loans and Advances and Pre-provisioning profit toTotal Loan and Advances as proxies for credit due to availability of data.3.3 Measurement of Profitability in Banks (Dependent Variables)Some of the profitability indicators in banks are Return on Equity (ROE), Return in Assets (ROA), Net interestMargin (NIM). Loan profitability (LPP) and the recurring earning power (REP). ROE and ROA were the indicatorsof measuring managerial efficiency (Ross 1994, Sabi 1996, Hassan 1999 and Samad 1998). The study used ROE asindicator for bank profitability.5.0 Discussion of Empirical Results5.1 Descriptive StatisticsTable 2 gives information about the descriptive statistics of the dependent variable, the independent variables andthe control variables. The average (standard deviation) performance of banks in the sample was 0.3674 (0.65687).This depicts that equity shareholders were able to generate a return of 36.74% which can be considered to be good.It also shows that the payback period of equity holders is about 3 years. Even though the average performance canbe considered as good, some banks recorded abysmal performance. The minimum recorded profitability was as lowas -46.84% while the maximum was about 211.1%. Apparently some banks performed poorly as compared to that ofthe industry. Also, Net Charge Off (impairments) to Total Loans and Advances averaged (standard deviation) at41.27% (1.026). This can be considered as high since on the average the proportion of loans impaired is about one-third of total loans and advances. This casts a slur on the quality of loans given out by banks in this sample. Theratio of non-performing loans to total loans and advances was astonishing. As high as 78.65% (1.738) of total loansand advances was considered to be non-performing. This confirms the numerous assertions that there is high level ofdefault among borrowers in Ghana, a reason which is mostly given by banks as the cause of high interest rate eventhough the prime rate has fallen significantly. This could be due to macroeconomic factors. High credit riskindicators in particular, non-performing loans, were due to macroeconomic instability that is, triggered byprohibitively interest/lending rates, fees, commission and depreciation of the cedis since the late 1990s whiles at thesame period bank were making higher profitability in Ghana, Aboagye-Debrah,(2007). This notwithstanding, it isalso clear that the high level of credit risks as shown by the above two indicators cannot be said to be widespreadamong the firms in the sample because of the high levels of standard deviations. Furthermore, pre-provision profits 5
  6. 6. to total loans and advances had a mean (standard deviation) of 14.03% (0.09). Firm size (log of total asset) was18.79 while the average (standard deviation) growth rate among the banks was 48.13% (0.3033). This shows asignificant growth in the industry. Debt capital represents a greater proportion of bank total capital. It representsabout 86.63% confirming earlier empirical evidence that banks are highly leveraged (Agyei, 2010). The lowstandard deviation 0f 0.0677 also confirms that it is represented of all banks in the sample.5.2 Variance Inflation Factor AnalysisMulticollinearity is a statistical phenomenon in which two or more predictor variables in a multiple regressionmodel are highly correlated. In this situation the coefficient estimates may change erratically in response to smallchanges in the model or the data. A number of tests can be used to test the presence of multicollinearity includingconstructing the regression matrix and checking the correlation among the variables or using the variance inflationfactor analysis. In this study, the researchers used the variance inflation factor (VIF) analysis. The variance inflationfactor quantifies the severity of multicollinearity in an ordinary least squares regression analysis. It provides anindex that measures how much the variance (the square of the estimates standard deviation) of an estimatedregression coefficient is increased because of collinearity. A common rule of thumb is that if VIF is greater than 5,then multicollinearity is high (Wikipedia, 2011). Also Kutner (2004) has proposed 10 as a cut off value. The resultsof the VIF test as shown in table three (3) shows that the presence of multicollinearity is minimal. The mean VIF is1.83 which is far below the rule of thumb.5.3 Discussion of Regression ResultsTable 4 presents the regression results of the analysis. The results of both the fixed and random effects model areconsistent for all the variables, with the exception of the growth variable. The results of the Hausman SpecificationTest shows that the fixed effects model is much more preferred to the random effects model. Consequently the fixedeffects model was used for the analysis. The study shows that credit risk, size of a bank, bank growth rate andcapital structure are the key factors which influence the profitability of the sampled banks. Quite interestingly, allthe variables in the study have a positive impact on firm performance.Credit risk has a positive and significant relationship with bank profitability or performance. This result indicatesthat as a bank’s risk of customer loan default increases, the bank is able to increase its profitability. According toBuchs and Mathisen (2005), despite high overhead costs and sizable provisioning, due to huge NPLs, Ghanaianbanks’ pretax returns on assets and equity are among the highest in the sub-saharan Africa. This result is quitesurprising because normally one would expect that as more customers fail to pay for facilities they have taken froma bank, the profitability of the bank should be harmed. This notwithstanding, it is possible for a bank (knowing verywell the inherent risk in a facility being given out) to increase the proportion of the default risk component in theinterest rate charged out on loans far more than the actual default risk. Eventually, banks which put up thisbehaviour are more likely to increase their profitability, even though credit risk may be high. This seems to be thecase among the banks in our study. In other words, the presence of credit risk allows banks to charge extremely highinterest rates which invariably lead to their high profitability. Bank of Ghana (BOG) report (2004) on Cost ofBanking in Ghana, makes it clear that, banks in Ghana still enjoy high profitability ratio in spite of the highoverhead cost which includes huge NPLs as a result of high interest rates or lending rates. Ghana Banking SurveyReport (2010), authored by PricewaterhouseCoopers, add that as non performing loan increased from GHS60millionin 2007 to GHS266million in 2009, total income of the banking industry became more than double fromGHS798million in 2007 to GHS.1.5 billion in 2009. It is therefore apparent that profitability of banks in Ghana, ishighly dependent on high interest rates which dampens financial intermediation, widens interest spreads at theexpenses of the private sector, possibly exacerbates the loan quality problem and ultimately restrict competition(Buchs and Mathisen,2005).The NPLs deteriorated from 13.2% in September 2009 to 18.1% in September 2010, netcharge-offs to gross loan ratio worsened from 8.5% to 10.1% in September 2010 and the industry’s return onequity(ROE) increased to 20.2% by the end of September 2010 from 19.8% by the end of September 2009.(BOG ,2010)This condition appears to partially explain the state of the Ghanaian banking industry. Even though the economy haswitnessed a fall in policy rate for quite some time, banks are reluctant to reduce their interest rates accordingly. Themost cited reason, which is difficult to refute, is that they have high bad loans in their books. In effect, the bankshave succeeded in widening their interest margins thus cashing in on the high credit risk. This, in a larger sense, alsogoes to support age long principle in finance that the higher the risk in an investment, the higher the expected return.Because banks in the Ghanaian economy have accepted to operate in a region with high default risk, they should be 6
  7. 7. compensated for the additional risk they are undertaking. Banks in Ghana justify charging extremely high interest/lending rates because credit risk is high as a results of inadequate collateral, inadequate borrower identification andgenerally high level of default, which notwithstanding, enjoy high levels of profitability (Kwaakye, 2011)The relationship between the size of a bank and its profitability is not only positive but also significant. Apparently,bigger banks perform better than smaller banks. Benefits associated with firm size, if managed properly, includeeconomies of scale, high bargaining power, ability to invest in research and development and improved efficiency ofoperation because of ability to afford better technologies. These benefits eventually lead to lower cost of operationand increased profitability. For instance, larger banks are more likely to attract bigger and cheaper loan facilities,because of their high collateral capacity. In the same way, they are more likely to win bigger deals with highprofitability prospects than smaller banks. This is what the results seem to reflect in the Ghanaian banking industry.High growth banks are better able to increase their profitability than low growth banks. Larger market growth orshares are as a result of efficiency that in turn lead to higher profitability (Aboagye-Debrah, 2007). As a bankembarks on growth strategies, the results show that the profitability of that bank is enhanced. This result is alsosignificant in explaining the profitability of banks in the sample. In other words, when banks managed their growthwell (in terms embarking on strategies to increase their interest margins), investors benefit tremendously from theimproved sales.Debt Capital has a positive and significant relationship with bank profitability. Banks that use more debt are betterable to increase their profitability than banks that do not. This is because of the added discipline and interest taxshield that high debt brings to the banking business. This result supports previous empirical work in Ghana (Agyei,2010) and also sits well with the agency cost hypothesis. Consequently, it lends support to Modigliani and Miller’sproposition 2, which summarizes that a firm’s value is not independent of its capital structure.6.0 ConclusionsBanks, just like all other forms of businesses are faced with numerous risks such as interest rate risk, exchange raterisk, liquidity risk, operating risk, political risk, technological risk and default risk(credit risk). Among these risks,the major cause of serious banking problems continues to be poor credit risk management. This study thereforelooked at the relationship between credit risk and profitability of some selected banks in Ghana. Interesting but quitesurprising results from the study showed that credit risk indicators have a positive and significant relationship withbank profitability signifying that, in Ghana, banks benefit from high default risk due (probably) to prohibitivelylending/interest rates, fees and commission. The results also depict that bank size, bank growth and bank debtcapital influence bank profitability positively and significantly. In fact, support was found for the agency costhypothesis theory of capital structure. It also confirmed that banks in the sample, performed well, used more debtcapital than equity and faced a high risk of default, over the study period.Consequently, the above results do not offer support for the numerous empirical works which conclude that creditrisk has a negative relationship with bank performance but rather sits well with the few ones which hold the viewthat credit risk improves bank profit. Thus while banks should be encouraged to reduce their lending ratesjudiciously and reduce fees and commission charge or even try to waive some, like ATM withdrawal charges, it isalso imperative that borrowers repay their loans on time and fully.References  Aboagye-Debrah, K (2007). Competition, Growth and Performance in the Banking Industry in Ghana. A thesis submitted to the Graduate School of St. Clements University.  Agyei, S. K. (2010). Capital Structure and Bank Performance in Ghana. University of Ghana. Unpublished Thesis.  Angbazo Lazarus (1997). Commercial banks net interest margins default risk interest rate risks and off balance sheet banking. Journal of Banking and Finance 2:55-87.  Annual Reports (2005-2009): Ghana Commercial Bank, Calbank, Unibank, UT. Bank, First Atlantic Merchant Bank and International Commercial Bank  Bank of Ghana (2004) Policy Brief: Cost of Banking in Ghana. An empirical assessment and implications. December 15, 2004.  Bank of Ghana (2011) Monetary Policy Committee Press Release. 18 February, 2011. 7
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  10. 10.  Zech, L (2003). Evaluating Credit Risk Exposure in Agriculture. A Thesis submitted to the faculty of the Graduate School of the University of Minnesota.List of TablesTABLE 1: Definition of variables (proxies) and Expected signsVARIABLE DEFINITION EXPECTED SIGNROE Profitability = Return on Equity (Net Income to Total Equity Fund) of Bank i in time tNCOTL Credit Risk = Net Charge Off (impairments) / Negative/ Positive Total Loans and Advances of Bank i in time tNPLR Credit Risk = Non Performing Loans / Total Negative/Positive Loans and Advances of Bank i in time tPPPNTLA Credit Risk = Pre-Provision Profit / Net Total Negative/Positive Loans and Advances of Bank i in time tSIZE Bank Size = the log of Total Assets of Bank i in Positive time tGRO Growth = Growth in Bank Interest income, year Positive on year.TDA Leverage = the ratio of Total Debt to Total Net Positive Assets for Bank i in time t. A measure for bank capital structure.Ε The error termTABLE 2: DESCRIPTIVE STATISTICS VAR. OBS. MEAN STD. DEV. MIN MAX ROE 30 0.36735 0.65697 -0.4684 2.111 NCOTL 30 0.41267 1.02592 0 4.89 NPLR 30 0.78649 1.73819 0.02 6.7352 PPPNTLA 30 0.14033 0.09084 0 0.33 SIZE 20 18.7966 1.25739 16.695 21.374 GRO 24 0.48125 0.30330 0 1.14 TDA 30 0.86625 0.06776 0.641 0.9733TABLE 3: VARIANCE INFLATION FACTOR TEST VAR. VIF 1/VIF PPPNTLA 3.24 0.309024 NPLR 1.93 0.518910 TDA 1.71 0.583547 NCOTL 1.61 0.622986 10
  11. 11. SIZE 1.35 0.742634GRO 1.17 0.856027Mean VIF 1.83TABLE 4: REGRESSION RESULTS (DEPENDENT VARIABLE: ROE) Fixed Effects Model Random Effects ModelVar. Coef. t-test Prob. Coef. z-test Prob.NCOTL 0.2826 7.57 0.000 0.2366 5.76 0.000NPLR 0.2593 11.86 0.000 0.2657 10.33 0.000PPPNTLA 1.4190 2.09 0.056 0.6338 0.84 0.400SIZE 0.1165 3.45 0.004 0.0636 1.84 0.066GRO 0.2861 1.87 0.083 -0.0429 -0.34 0.736TDA 1.0862 1.97 0.069 0.7100 1.11 0.268CONS -3.4687 -3.79 0.002 -1.8621 -2.10 0.036R-sq 0.9221 R-sq. 0.9527Wald chi2 81.64 Wald chi2 342.17Prob. 0.0000 Prob. 0.0000Haus. Test: 12.64 Chi2: 12.64 Prob. 0.0491 11